CFA Practice Question

CFA Practice Question

An analyst with Smith, Kleen & Beetchnutty is trying to determine the earnings multiple of a stock market series composed of firms in the basic materials business. In her research, the analyst has gathered the following information:

D0: $1.10
EPS: $4.30
k: 13.75% per year
g: 10.50% per year

Using this information, what is the earnings multiplier of this stock market series? Further, is this multiple realistic for firms in the basic materials business?
A. 7.88, no
B. 7.88, yes
C. 10.54, no
Explanation: To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/E = [(D1 / E1) / (k-g), where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.

In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following: P/E of a stock market series = [($1.10*1.105 / ($4.30*1.105)) / (0.1375 - 0.105)] = 7.88

This is a rather low multiple, appropriate for slow growth industries. The fact that the index under examination is a compilation of firms in the basic materials business substantiates this low multiple because firms in this line of business are not expected to grow very rapidly. Further, firms in the basic materials business are also likely to have a relatively high dividend payout ratio, as evidenced in this example.

User Contributed Comments 7

User Comment
Mdavid But the growth rate is decent, 10.5%, not that small. It does not seem reasonable to have such a low P/E (7.88). maybe the required rate of return is too high?
escempep I would say that a PE of 7,88 implies an annual rate of return of 12,7% (1/7,88) which is not consistent with the required rate of return of 13,75%
gazza77 Basic Materials has been booming in Australia over the last 5-7 years with multiples raning from 12-40.
chantal The forward PE is calculated. Normally the current PE in Mock 1 and 2 exams is based on the TTM earnings and the forward PE is based on the growth adjusted earnings.
at0899 this question is so time-biased- the commodity boom has led to very high multiples for all material stocks while this may not have been true 20 years ago...
luyao How can we know if this is a realistic multiple if they give us no information on the industry or at least industry comparable ratios???
AlVMc This is a stupid question!
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